Energy Companies That Are Ideal MLPs

Investors who seek fat dividends to pad their portfolios really like master limited partnerships, and nowadays it's en vogue for energy companies to spin off parts of their business into MLPs. For the most part, the MLP space is dominated by energy infrastructure and pipeline companies because of the stable cash flows that they generate, but several exploration and production companies are sprouting up in the MLP space as well.

To be an E&P MLP, though, you have to have some very distinct traits. Let's take a look at what it takes for an E&P company to be a successful MLP and why Ultra Petroleum (NYSE: UPL) and Denbury Resources (NYSE: DNR) could be a perfect fit.

The criteriaMLPs have those high yields because they return almost all of their distributable cash to their shareholders, which means that they need to have very predictable cash flows. To make this possible, E&P companies need to execute these parts of the business very well:

Squeeze every last drop of oil from mature, long life assets: The reason that most E&P MLPs are successful is because they buy up out-of-favor oil and gas assets and milk them dry through operational efficiencies, just like Vanguard Natural Resources (NASDAQ: VNR) .

Source: Vanguard Natural Resources investor presentation.

Turning these mature assets into cash cows that don't require much in terms of capital expenditures is exactly what MLPs are looking for.In 2012, Vanguard spent about $50 million in operational capex, but was able to turn that into more than $230 million in adjusted EBITDA, right where an MLP wants to be. Vanguard's ability to turn these overlooked oil and gas assets into cash cows allows Vanguard to give cash back to shareholders at a yield of 8.8% while maintaing a distribution coverage ratio greater than 1, which is a measure of how much distributable cash flow a company takes in divided by how much it forks over in distribution payments.

Strong hedging portfolio in order to take some uncertainty out of commodity markets:The Achilles' heel of a company looking for stable cash flows is the volatility of commodity prices. In order to mitigate this risk, MLPs write several commodity swaps and futures contracts to lock in a price for its assets.

Source: Linn Energy investor presentation.

While almost all E&P companies hedge the price of oil and gas, MLPs will do this to a much higher degree. Linn Energy (NASDAQ: LINE) goes so far in this hedging philosophy that it has 100% of its future production hedged out to 2016. This isn't just unique to Linn, either. On average, E&P MLPs have their production hedged at least 25% more than a typical E&P all the way to 2015.

Now, not every E&P company is fit to be an MLP, but Ultra and Denbury are prime examples of ones that have the stuff to be MLPs.

The candidatesUltra Petroleum: Like many of the other MLPs out there, Ultra has a tendency to seek out what many other companies would consider less desirable assets like the Pinedale field in Wyoming. But Ultra has seemed to find the sweet spot in this field that is producing natural gas at a breakeven cost of $2.80. This field also has one-year production decline rates around 25%, which is much better than some of the sexy oil and gas plays like the Marcellus, which expects production to decline as much as 67% within the first 100 days.

The company is also looking to make its first splash into oil by acquiring assets in the Uinta Basin. Ultra's management estimates that the worst-case breakeven cost for these wells is $60 per barrel. Ultra may not have a strong hedging portfolio right now, vut it certainly has the assets and operations mind-set to be a strong MLP candidate.

Denbury Resources: As an enhanced oil recovery specialist, Denbury is ideally suited for the MLP space. This company specializes in using CO2 to pull oil from older, sometimes abandoned oil formations and milking a few extra million barrels of oil from them. Denbury estimates that through this method, it can increase the recovery rate from a traditional oil field from 38% to 55%. Using this estimate, the company sees a potential for 10.7 billion barrels of recoverable from older fields in just the Rocky Mountains and the Gulf Coast regions.

What makes this ideal for MLP status is that the production from these aging fields is based on its CO2 flooding program rather than well performance, which is planned out all the way to 2019 based on its current assets. With a very predictable production schedule and assets that throw off boatloads of cash once the initial infrastrucutre is in place, Denbury could make investors very happy as an MLP. In fact, management has even said it is considering the move.

What a Fool believesThere are probably lots of Ultra and Denbury shareholders out there who would love for these companies to turn into MLPs. Going from a C Corp to a full-blown MLP isn't that simple, though, so seeing these companies make an attempt at either becoming an MLP or spinning off some of its assets into an MLP is probably a ways off. Still, all that love for MLPs should give these companies' management teams something to consider.

Who will join Denbury in dominating the American energy boom?Denbury is carving out a position as a top American energy company, but it isn't alone. The transformation of the American energy space is creating investment opportunities everywhere, but picking the right ones will mean the difference between a flash in the pan and a long-term jewel. For this reason, we have put together a comprehensive look at three energy companies set to soar during this transformation in the energy industry. Find out which two have joined Denbury on our list of companies that are spreading their wings in our special report "3 Stocks for the American Energy Bonanza." Simply click here and we'll give you free access to this valuable investing resource.

The Motley Fool recommends and owns shares of Ultra Petroleum. It also owns shares of Denbury Resources and has the following options on Ultra Petroleum: long January 2014 $30 calls, long January 2014 $40 calls, and long January 2014 $50 calls. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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